Mary Goldman, Nick Spencer and Esin Yilmaz Caglar of the The IFoA's Biodiversity Working Party explores nature-related risks, some current challenges in scenario analysis, and what it means for actuaries.
The Green Finance Institute’s (GFI) April 2024 report on the UK’s economic dependency on nature, prepared for the UK Treasury, concludes: “The gradual impacts of environmental degradation on the economy are as detrimental or more so than climate change in the near-term - and the chronic year-to-year changes lead to losses that are as important as more sudden [financial market] shocks.” These findings are similar to the IFoA’s 2024 climate risk alert highlighting the need for actuaries to understand gaps in climate risk modelling. The challenges of the dual climate-nature crisis are increasingly being seen as a serious actuarial concern.
Nature risks capture the negative impacts from biodiversity loss, ecosystem degradation, and natural system changes. These risks are closely tied to climate change, as climate breakdown worsens biodiversity loss, and vice versa. The mechanisms driving nature and climate risks often overlap, with some nature-related risks stemming from climate issues and some climate risks arising from nature degradation. Both must be addressed together in a coherent framework for effective risk analysis.
Actuaries need to adjust their methods to properly account for the costs of both climate and nature risks. Although integrating climate-nature scenarios is complex, actuaries must include these risks in their frameworks. Despite the clear impacts of nature-related risks, they are often overlooked in financial markets and institutional scenarios, partly due to a lack of transparency and disclosure about these risks. There are significant information asymmetries associated with lack of disclosure of nature-related risks and impacts. These include:
These distortions create the potential for these risks to be systematically underpriced with the risks of sudden market shocks when prices are corrected.
There are already many examples of this in the literature we can examine to understand what the scope and scale of nature risk might be now, and in the future.
What follows is an exploration of:
The dual impacts of nature and climate risks are already visible on company balance sheets through the impacts of supply chain fragility, business interruption, and resource scarcity. For example:
Given these examples, integrated risk assessment is essential to accurately capture the combined impacts of climate and nature risks. However, developing effective scenario analysis to account for these complex risks presents significant challenges. The next section will explore these challenges and then move on to discuss how scenario analysis frameworks can be adapted to better address both nature and climate-related risks.
Climate scenarios explore various dynamics, but the standard scenarios do not explicitly address nature-related risks, and they do not quantify climate and nature-related risk from an integrated analytical framework. Despite these challenges, existing net-zero scenarios often rely heavily on nature-based solutions post 2030 to align global emissions with a ‘well below’ 2°C future. There are significant analytical challenges associated with extending existing frameworks to include nature-related risks. In particular, current frameworks struggle to include potential shocks and macro-economic effects nor the impacts from supply shocks such as the food inflation created from global-wide poor harvests.
Despite these challenges, there is, and needs to be, growing attention to nature-risk. Regulators, standard setters and policymakers are recognising that nature and climate are linked and require a joined-up approach to accurately capture the scale and scope of risk.
Voluntary and mandatory reporting regulations have spurred climate-related risk reporting, with central banks stress-testing financial institutions against climate scenarios from the Network for Greening the Financial System (NGFS). The NGFS is now working on a framework to holistically consider both climate and nature-related risks, driven by the need to mobilise capital for nature-positive investments.
Many environmental risks, like many climate risks, are systemic. They can disrupt multiple sectors simultaneously and trigger widespread financial instability. Recognising this, policymakers are beginning to develop approaches to support addressing the material risks posed by environmental degradation. Reports like Assessing the Materiality of Nature-Related Financial Risks for the UK highlight the need for benchmark scenarios to understand the causal mechanisms between climate, nature, and the financial system.
Scenarios are crucial tools for actuaries, enabling them to quantify risk under different future outcomes. However, nature scenario analysis faces many of the same challenges as climate scenario analysis: data scarcity, model limitations, and the complex dependencies of economic sectors on natural systems.
Unlike greenhouse gas emissions which are essentially location agnostic, nature is extremely place-based with nature-related risks being more or less material based on the particular natural features of different environments. In addition, nature is material and relevant at different scales and timelines to climate risk. While unequivocable acute and chronic anthropomorphic climate impacts are relatively recent, acute and chronic anthropomorphic nature risk impacts have been felt for many decades (or even centuries). There are many examples of how natural systems in different geographies have already passed tipping points and will not recover to their previous states, thereby removing a natural ecosystem service and the associated costs associated with this sort of phase change. See our article on biodiversity tipping points for more information on this dynamic.
Examples of these sorts of tipping point being crossed include:
Narrative scenarios are useful for exploring biodiversity loss and environmental degradation where data is insufficient for quantitative analysis. These scenarios account for the spatial and temporal complexity of nature risks, which differ from climate risks. They enable selecting appropriate quantitative frameworks for further analysis, overcoming limitations in traditional models. Unlike quantitative scenarios, which struggle with uncertainty, qualitative scenarios better capture real-world volatility, including financial and policy changes. Critically, qualitative scenarios can give us enough information to inform decisions and motivate action, without the need for quantification.
Environmental risks become systemic when they disrupt critical ecosystem services. The 2018 IPBES assessment predicts worsening biodiversity loss under most future scenarios, leading to cascading disruptions in areas like agriculture, which impact supply chains, food security, and economic stability. These disruptions are expected to increase in severity over time. To address this, clearer integration of climate and nature risks is needed, along with narrative scenario analysis. This approach has been applied in the UK, combining narrative analysis with macroeconomic modelling and financial risk assessments, examining sector-specific impacts of nature-related risks (see: GFI April 2024 report).
The task ahead for actuaries is clear: develop robust scenario analysis methodologies that capture these interconnections without being constrained by existing frameworks. This approach requires considering the different geographic and temporal distributions of nature risks and understanding their interactions with climate risks. Narrative scenario analysis is a flexible framework that enables actuaries to take the first step on this conceptually challenging, though critically urgent, journey.
We will shortly be organising a workshop with leading practitioners to share insights on current narrative scenarios and ways to better link these within our sustainability scenarios and stress terms. Actuaries need to develop their knowledge of these efforts, the relative impacts of nature-based risks and the impact on their advice and calculations on the potential for nature-related risks being equal to greater than climate-related risks.
